Why liquidity dries up when you need it most
If you ask what an asset is worth, you get one number. If you ask what it would sell for today, in full, to a buyer who knows you have to sell, you often get a lower one. The difference between those two numbers comes down to liquidity. In normal markets investors tend to ignore it, and in stressed markets it can matter more than anything else in the portfolio.
The standard definition of liquidity is how quickly an asset can be turned into cash without moving its price much. That definition makes it sound like a fixed trait of the asset. In practice it depends on the market around the asset at a given moment, and it can disappear within hours.
Two positions worth $10 million each
Picture two holdings that each show a value of $10 million on a Friday statement.
The first is a large-company stock that trades hundreds of millions of dollars a day. Selling the whole position on Monday costs a small spread and maybe a little slippage, and the proceeds land close to the statement value.
The second is a bond issued by a mid-sized company that trades a few times a week. There is no continuous market for it. To sell, you ask dealers for a price, and the price depends on whether they want the bond, whether they can hedge it, and how much of the issue you're trying to sell. The statement value comes from a pricing service. It may be a fair estimate of what a small piece would bring in a quiet week, but it says little about what the full position would bring on a bad day.
Both positions are marked at $10 million. Only the first can reliably be sold for close to that amount.
Why it disappears all at once
Liquidity tends to fall at the same moment asset prices fall, so it offers the least help at the worst time.
Take a leveraged investor with $100 of assets, funded with $20 of its own money and $80 of borrowing. Prices drop 10%. The assets are now worth $90 while the debt stays at $80, so the investor's own capital has fallen from $20 to $10. The lender sees the same numbers and asks for the original ratio to be restored, which forces the investor to sell.
The investor sells what can be sold quickly: large-company stocks, government bonds and other assets with plenty of buyers. The hard-to-sell positions stay in the portfolio, because selling them fast would mean accepting a steep discount. As a result, the easy-to-sell assets drop in price because they are the ones being sold, the remaining portfolio becomes harder to sell than before, and other leveraged investors facing similar margin calls are selling the same assets on the same day.
This process is called deleveraging. It explains a pattern that surprises people early in a crisis, when some of the highest-quality assets fall sharply. They drop because they are the easiest things to sell, even though investors' view of them hasn't changed.
Market liquidity and funding liquidity
The word liquidity covers two different things, and most crises involve both.
Market liquidity is the ability to sell an asset without pushing its price down. It depends on how many buyers are around, how much capital dealers are willing to put to work, and how wide the spread is between the bid and the offer.
Funding liquidity is the ability to borrow against the assets you own. It depends on whether lenders are willing to lend, how large a haircut they apply to your collateral, and whether they renew existing loans when they come due.
Each one affects the other. When funding gets harder to find, borrowers have to sell, and that weakens market liquidity. When market liquidity weakens, lenders raise haircuts because the collateral has become harder to sell, and that makes funding harder to find. This loop helps explain why credit problems can escalate over a few days, and why central banks step into funding markets during a panic instead of waiting for prices to settle.
March 2020 shows how far this can go. Stress appeared in stocks and corporate bonds, and also in the market for US Treasury securities, normally the easiest securities in the world to trade, as investors sold whatever they could to raise cash. When trading breaks down even in Treasuries, the trouble is in how the market itself is functioning.
What it means for individual investors
Most people will never face a margin call, but the same ideas apply in three practical ways.
Know which holdings have an active market. Listed stocks and government bonds usually do. Private funds, non-traded real estate funds, thinly traded small companies and anything with a redemption limit in its documents may not, whatever the statement shows. A statement value is an estimate made under normal conditions.
Read redemption terms carefully. A fund that allows withdrawals once a quarter with 60 days' notice offers access to your money that works in calm markets. Those terms exist so the manager isn't forced to sell into a falling market. That protects the fund, and it's worth understanding before you need the cash.
Keep near-term cash needs in liquid assets. Owning hard-to-sell investments is fine on its own. Trouble starts when you own them and also need cash on a schedule that assumes you can sell them. A forced sale turns a loss on paper into a real one, usually at a poor price.
The terms involved
Finance has a lot of vocabulary for this area because these situations come up often. Liquidity is the ability to sell. Slippage is the gap between the price you expected and the price you got. A haircut is the discount a lender applies to collateral. Deleveraging is the unwinding of borrowed positions. Solvency means assets are worth more than debts.
The last distinction is worth remembering. A firm with a liquidity problem can't sell assets today at an acceptable price. A firm with a solvency problem owes more than its assets are worth. Firms in trouble often describe their situation as the first when it is really the second, and during a panic it is usually hard to tell which one you're looking at until later.
The archive has the questions these terms came from, and the glossary defines each one.
Common questions
What does liquidity mean in finance?
How quickly an asset can be turned into cash without moving its price much. The phrasing makes it sound like a fixed property of the asset, but it depends on the market around that asset at a given moment, and it can disappear within hours.
Why does liquidity disappear exactly when it is needed?
Because the conditions that make you want to sell are the conditions that make others unwilling to buy. An asset that trades freely in a calm market can become effectively unsellable in a panic, which is how a funding problem at one firm spreads to others.
What is the difference between an asset's value and what it would sell for?
Value is the number on the statement. What it would sell for is what a buyer pays today, in full, knowing you have to sell. In normal markets investors ignore the gap. In stressed ones it can matter more than anything else in the portfolio.
Guess Macro is a daily word game built on this vocabulary. Five clues, one word each.